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The Financial System Made Simple

As perceptively as any economist or regulator, and more
thoroughly than most, Andrew Haldane has written the book on
the financial crisis and the reforms it has necessitated 
except his is not literally a book. It is a compendium of
writings and presentations, all in the public domain thanks to
the Bank of England, where Haldane is executive director for
financial stability and a member of the Financial Policy
Committee.

Haldanes work charts a path from when
macroprudential policy [was] a new ideology and a big
idea  as he said at a Federal Reserve Bank of
Chicago conference in May 2009  to a current bout of
revisionism among an increasingly vocal cadre of financial
policy experts engaging in what might be called complexity
backlash.

Their reaction stems from a deepening understanding of how
staggeringly complicated the global financial system and its
various institutional and market structures have become, which
increases their vulnerability to unforeseen risks. Thats
not to mention the thousands of pages of new regulations that
further tangle the web, creating what Karen Shaw Petrou, head
of Washington-based consulting firm Federal Financial
Analytics, has termed complexity risk.

If the biggest banks cant be managed or regulated with
a great degree of confidence, then the solution may logically
lie in simplification  unwinding or rolling back the
complexity that has been cited as a root cause of the
200709 meltdown and which continues to vex
policymakers.

Proposed simplicity solutions take various forms, including
limiting the size of banks, breaking up the systemically
important ones or separating commercial and investment banking
in the spirit of the U.S. Volcker rule. While the latter,
however, began as a simple proposal to reinstate principles of
the Glass-Steagall Act of 1933, it required some 30 pages to
spell out in the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 and has generated hundreds more pages of
rulemaking detail prior to formal implementation.

Such is modern finance: Complexity is not easily contained.
Its theoretical underpinnings were explored by the Bank of
Englands Haldane in an April 2009 speech in Amsterdam. He
reviewed the state of financial services in the context of
complex adaptive systems: Complex because these networks
were a cats cradle of interconnections . . . . Adaptive
because behavior in these networks was driven by interactions
between optimizing, but confused, agents.

The terminology, though perhaps new to many in
Haldanes audience back then, was grounded in complex
systems theory, a multidisciplinary field of inquiry that has
been championed by the Santa Fe Institute since the 1980s and
has shed light on such areas as epidemiology and network
theory, as well as on finance. Haldane contended that the
pre-deregulation, compartmentalized financial industry had more
network robustness  less susceptibility to
contagion  than does todays world of
interbreeded commercial and investment banks.
That is one reason Glass-Steagall is back on the
international policy agenda, he said. It may be the
wrong or too narrow an answer. But it asks the right question:
Can network structure be altered to improve network
robustness?

Flash forward to this year and The Dog and the
Frisbee, the paper that Haldane co-wrote with Bank of
England economist Vasileios Madouros and presented at the
Federal Reserve Bank of Kansas Citys economic policy
symposium on August 31 in Jackson Hole, Wyoming. The paper
compares the feat of a dog catching a Frisbee to financial
authorities attempts to catch a crisis.

Why did no regulator predict the crisis? The answer is
simple. Or, rather, it is complexity, states the paper,
as it explores how the buildup of decades of regulatory
complexity ultimately proved not just costly and
cumbersome, but sub-optimal for crisis control. In financial
regulation, less may be more.

We will aim to keep our rules as simple as
possible, U.S. Treasury undersecretary for domestic
finance Mary Miller affirmed recently, but recognize that
simplicity is not always synonymous with
smart.  She shot back at Haldanes
paper: Unfortunately, reality is more
complicated.

Jeffrey Kutler is editor-in-chief of Risk Professional
magazine, published by the Global Association of Risk
Professionals.